Examining A Covered Call Trade

Mastering covered call writing requires us to learn from our mistakes and not repeating them. We can then utilize a series of guidelines and rules that will guide us to the highest possible returns with the least amount of risk. Maximizing profits with capital preservation in mind is what the BCI methodology is all about.

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In 2011,  a BCI member sent me an email describing a series of trades he made with GMCR. After responding to his inquiries I realized that there was a great learning lesson here that could benefit many others as well. With his permission I presented the key parts of his email. The example is such a valuable tool that I decided to re-publish it as a review to all our members:

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Hi Alan,

I have a few questions regarding the Ellman Calculator.  Let me give you a recent trade as an example first.  On 6/01/2011, I bought 100 shares of GMCR at $80.24 and sold 1 GMCR Jun11 80 Call at $2.90.  A week later the price had dropped and I was able to buy back the Jun11 80 Call at $0.27 and sell a Jul11 77.50 Call at $2.77. By the first week of July the price had shot up in the high $80s and I wanted to participate in the gain, so I bought back the Jul11 77.50 call for $14.60 and sold a Jul11 92.50 Call at $1.95. The July 92.50 call expired with the price around $91.00.  I then sold an Aug11 95 Call at $4.25 on 7/19/2011.  On 7/28/2011, GMCR shot up over 18%, so I bought back the Aug11 95 Call at $11.50 and sold 100 shares of GMCR at $106.06.

Here’s the trade in table form:

• 6-1-11: Buy 100 x GMCR @ $80.24
• 6-2-11: Sell 1 x June $80 call @ $2.90
• 6-10-11: B-T-C 1 x June $80 call @ $0.27
• 6-10-11: S-T-O 1 x July $77.50 call @ $2.77
• 7-6-11: B-T-C 1 x July $77.50 call @ $14.60
• 7-6-11: S-T-O 1 July $92.50 call @ 1.95
• 7-15-11: July $92.50 call expires worthless; stock value $91
• 7-19-11: Sell 1 x August $95 call @ $4.25
• 7-28-11: B-T-C 1 x August $95 call @ $11.50
• 7-28-11: Sell 100 x GMCR @ $106.06

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For someone new to covered call writing this investor has many of the principles of this strategy mastered. He also has the motivation and determination to put them to use. VERY IMPRESSIVE! For all of us (including me), the learning process never stops and there oftentimes are ways to enhance our bottom line returns. So let’s sit back, relax and evaluate the various stages of these trades:

6-1-11: Buy 100 x GMCR @ $80.24 and

6-2-11: Sell 1 x June $80 call @ $2.90

Initial profit is $2.90 – $0.24/$80.24 – $0.24 = 3.3%. Here we deduct the intrinsic value of the premium and divide it by the initial cost minus the intrinsic value. Good job!

6-10-11: B-T-C 1 x June $80 call @ $0.27

Buy back the option @ $0.27 which meets our 10% guideline. Nice work!

6-10-11: S-T-O 1 x July $77.50 call @ $2.77

You rolled down (to the $77.50 call) and out (to the July call), a strategy I never use. You are assuming more obligation on a declining equity (we did not know at that time it would appreciate the way it did but you shut the door on benefiting if it did). Since you were early in the June contract, consider waiting to hit a double you would have! (See pages 259-261 of Encyclopedia for Covered Call Writing). If the share price does not rebound, consider rolling down in the same month or closing the position if the stock continues to decline. Before the lower strike was sold your cost basis is $80. When you buy-to-close (BTC) @ .27 and sell-to-open (STO) @ $2.77 there is a net credit of $2.50. Since the $77.50 call is 2.50 in-the-money, the ROO is 0. Again, I never roll out and down. At this point in time, your cost basis (for purposes of making the best investment decisions, not for tax purposes) is $77.50. You made no money and lost no money on the last trade.

7-6-11: BTC 1 x July $77.50 call @ $14.60

Here you rolled up in the same month also a strategy I rarely use  for fear of a decline due to profit-taking (after a stock price has risen sharply in a short period of time) and it usually does not put a lot of cash in our pockets. The net debit is (-) 12.65 and the unrealized credit is the current market value – 77.50, probably a wash, again a no-profit trade (but a great learning experience…I’ve been there!). Take a look at this link for the  mid-contract unwind, a strategy I developed after I wrote Exit Strategies….This may have been a better approach. It is used when a strike moves DEEP in-the-money and the time value of the premium approaches zero.

7-15-11: July $92.50 call expires worthless; stock value $91

As we move to the next month make sure the stock still meets our system criteria INCLUDING NO EARNINGS REPORT …uh oh).

7-19-11: Sell 1 x August $95 call @ $4.25

Now for my most important comment: You sold the August 95 call with an upcoming 7-28 earnings report. Avoid doing this at all costs. Either sell the stock prior to the 28^th or own the stock through the report but do not cap it by selling the call. This way you can participate if the report is positive (evidently it was). After the report and the price settles, feel free to sell the call if the stock meets your requirements. You could have sold the stock for $106 without paying the $11.50 to buy back an option you probably won’t sell in the future.

7-28-11: B-T-C 1 x August $95 call @ $11.50 and

Sell 100 x GMCR @ $106.06:

Ouch, we had to buy back a call we never should have sold. Many years ago when I first started educating myself on this strategy I did this very thing many more times than I care to think about before I made this rule for myself and now share with you: never sell a covered call option on a stock about to report earnings.

I created a chart from June 1st to July 28th, the first and last trades made by this investor highlighting BCI strategies to consider:

Covered call writing trade

Trading GMCR: 6-1-11 to 7-28-11

Note the following:

• The chart shows the June and July expirations
• We initially buy GMCR @ $80.24 and sell the June $80 @ $2.90 for a $266 initial profit (3.3%, 1-month return)
• In June we  BTC the short options position and STO the same $80 strike for (let’s say one third the original premium) for $1 generating another $73 in profit ($1 – $0.27). This is called “hitting a double”. Total profit so far = $266 + $73 = 339 = 4.2%, 1-month return
• The June contracts close right about $80 so we can roll out to the July $80 strike or roll out and up to the July $85. As it turns out the latter would have returned the most but let’s err on the conservative side and say we went with the $80 call and generated another $266 per contract for a final total of $339 + $266 = $605 = 7.6%, 2-month return or 45% annualized.
• When the July contracts expire, the price is well above the $80 strike or even the $85 strike for that matter. We can allow share assignment and move on to another equity or buy back the option at parity (almost all intrinsic value) and await the earnings results.

Conclusion: There are so many ways to enter, manage and close our stock and option positions. By analyzing these different approaches and having a complete understanding of the advantages and disadvantages of each, we will all become better investors and ultimately financially independent.

My grandson just turned  1:

The youngest Blue Collar Investor

Next live seminar:

June 8th: Baltimore, Maryland

http://www.aaii.com/chapters/meeting?mtg=2440&ChapterID=79

New seminar just added:

Phoenix, AZ: April, 2014

Date and venue to follow

***I will not be presenting live seminars over the summer but will get back into the action in September in Philadelphia. I really enjoy meeting our BCI members as I travel throughout the US.

Market tone:

U.S. stock markets hiccupped this week, but still finished the month with healthy gains. The Dow Jones Industrial Average fell 208.96 points or 1.4% to close on Friday at 15,115.57. For the week the index is down 1.2%. The Nasdaq Composite Index dropped 35.38 points or 1% to close at 3,455.91, while notching a 0.1% loss for the week. Meanwhile the benchmark S&P 500 Index fell 23.67 or 1.4% on Friday to close at 1,630.74. For the week the benchmark index lost 1.1%. This week’s reports:

• Real GDP (after-inflation comprehensive scorecard of the country’s economic health. GDP represents the total value of the country’s production and consists of purchases of domestically produced goods and services by individuals, businesses, foreigners, and the government) grew at an annual rate of 2.4% for the 1st quarter compared to 0.4% in the 4th quarter, according to the Commerce Department. This was slightly below expectations mainly due to a decline in government spending
• Personal income (a report of the income that households receive from all sources, such as wages and salaries, employer contributions to pension plans, rental properties, and
  dividends and interest. It also includes data on personal spending for durable goods (products with an expected life of more than one year) and nondurable goods and services, as well as information on the percentage of their income that households are saving. Since income is the major determinant of spending, the report is an indicator of future consumer spending patterns) was flat in April after a 0.3% increase in March
• The Conference Board’s index of consumer confidence jumped to 76.2 in May from 69.0 in April, the highest reading since February, 2008 and its second straight monthly increase. This was well ahead of analyst’s expectations and most likely related to a healthier outlook for the labor market and the economy in general
• The S&P/Case-Shiller Home Price Indicies, the leading measure of US home prices, posted double-digit gains for all 3 of its indexes for the 12 months ending March 31st. All 20 cities showed advances with Phoenix, San Francisco and Las Vegas being the strongest while NY, Cleveland and Boston being the weakest but still showing gains
•  Initial jobless claims for the week ending May 25th came in @ 354,000, slightly higher than the 340,000 expected

For the week, the S&P 500 fell by 1.4% for a year-to-date return of 15.5%, including dividends.

Summary:

IBD: Uptrend under pressure

BCI: Moderately bullish, favoring out-of-the-money strikes

My best to all,

Alan ([email protected])

www.thebluecollarinvestor.com